Financial Crisis Act II: Wall Street Sharks

When the bailout passed, I first thought this post was moot. But then I reconsidered. There’s still plenty of time to affect the implementation and several lessons to be learned. Also, when I’m pissed off, it’s nice to know that I have a good reason.

In Act I, we saw how government meddling overheated the housing and mortgage markets. Now we’ll see how Wall Street took advantage of this opportunity and also apportion some blame to ourselves.

That’s right. I think regular people are also to blame. That’s because most of them don’t understand, deep down, that there ain’t no such thing as a free lunch (TANSTAAFL). When you put your money in a bank, you’re not storing it. Why do you think the bank pays you interest or bears all the expenses of processing your checks? Because they use the money you deposit to make loans to other people and engage in other profitable financial transactions.

“Hah!” you say, “They should be careful with my money.” Oh, really? Do you own stocks, even through a mutual fund? I bet you like to see a healthy return on those investments, right? Well, there are probably more than a few financial services firms (at least transitively) in your portfolio that did quite well for many years. The people that run those firms are under tremendous pressure to show a profit so they can please stockholders like you, which means squeezing as much potential out of the deposits of account holders like you.

A brief digression about money market accounts. A lot of people are up in arms that their money market accounts have or may “break the buck” and that they may not have full access to their funds. Why exactly did they think their money market accounts had a higher interest rate than vanilla savings accounts? Didn’t they realize they were being compensated for the additional risk they were taking? They shopped around for the money market fund with the best interest rate and then were surprised when those funds turned out to be the riskiest. Did they think those fund managers had a magic want that created safe money? No, this extra interest was a risk premium. But don’t worry, as we shall see, even Wall Street “professionals” with advanced degrees forget that the first word in “risk premium” is “risk”.

Which brings us to the concepts of reserves and insurance. Financial institutions are supposed to make sure they have enough capital on hand to disburse funds when asked and weather potential losses on transactions. The government enforces these requirements to balance the desires of account holders for safety and stockholders for returns (even though in many cases these are the same people). Obviously, the more capital institutions need to keep on hand, the less they can “put to work” making money. Often, they try to buy various forms of insurance against losses to reduce the reserve requirements. They also try to coerce regulators into lowering the requirements, which is easy to do when they’re making billions of dollars a year.

OK, now we’re ready to talk about how Wall Street is to blame. Because home ownership had become seen as a signal of stability and prosperity, consumers were desperate to own homes and politicians were desperate to oblige them. When there are two desperate parties that want a transaction to happen, financiers smell an opportunity.

The opportunity was big. Because subprime mortages are inherently more risky, borrowers are willing to pay lenders a substantial risk premium. Or if you prefer the more populist narrative, lenders can trick borrowers into taking out high cost loans. In either case, by opening up the mortgage market to an entirely new class of customers that were willing to pay high prices, there was a huge stream of money for financiers to sink their teeth into. But they forgot about the “risk” in “risk premium.”

Now, they didn’t make the small mistakes of normal people who fundamentally don’t understand risk. They made the truly ginormous mistakes possible only for the well-educated, highly intelligent, and extremely ambitious. There are two types of risk in finance: idiosyncratic risk and systematic risk. You can diversify away idiosyncratic risk but not systemic risk. The problem is that it’s sometimes really hard to tell the difference. The details are incredibly complicated, but here’s the overview. The guys at a variety of Wall Street firms in charge of coming up with financial products related to MBSs thought they had discovered idiosyncratic risks that they could diverisfy away with complex financial instruments. However, these were really systemic risks in disguise so the risk was just moved around to where no single firm could see it.

So Firm A takes on a bunch of mortgage related risk. They want to get rid of it to free up reserves for other profitable transactions so they trade some instruments designed to insure against the risk with Firm B. Now Firm B wants to get rid of the risk, so they trade some different instruments with Firm C. And so on… At this point, everybody’s ability to keep their reserves low is dependent on the value of trades they’ve made with a bunch of other firms who have in turn made a bunch of trades with still other firms. If something bad starts happening to more than a couple of firms (that’s the “systemic” in “systemic risk” BTW), the strength of everyone’s insurance will go down. So they’ll have to increase their cash on hand to cover their reserve requirements. The first step is selling MBS-related assets, which everyone else also wants to sell, which means they will be going down in value. The second step is selling other assets and stopping the purchase of new risky assets, which everyone else also wants to do. Can you say, “meltdown”? I knew you could.

Luckily, every firm has some geeks in the back room that work in Risk Management whose job it is to be on the lookout for this kind of thing. Let’s go back in time to before there was even a whiff of crisis. Most of the scenarios that these guys run on supercomputers with fancy software show that everything is cool. But there are some extreme cases that look very bad. The geeks go to the suits running their respective firms and say, “Uh, there are some scenarios that seem to indicate we’re underestimating the risks associated with MBSs.” But the technical details are very difficult to understand. So the suits have to choose whether they go to the tremendous amount of effort necessary to comprehend what the geeks are saying. If a suit does go to the effort and ends up believing what his geeks say, what will happen?

Well, he’ll have to dial back his firm’s participation in the MBS market. His firm will make less money. His bonus will go down. He’ll have to on TV and explain why his firm is performing worse than competing firms. At the shareholder meeting, he’ll have a lot of explaining to do. So he doesn’t want to understand. Besides, what are the odds? His geeks say, “Oh a few percent.” Most likely, this suit will have “earned” a ton of bonuses and moved on by then. And the geeks might be wrong anyway. Best not to rock the boat. Are any competing firms getting out of MBSs? No? Then he’ll stay in too. He doesn’t want to be the only one not making money here.

And so we now arrive at the reason for being pissed off. As we saw yesterday, politicians layed the foundation that made the crisis possible. So Wall Street suits moved in and built a house of cards. Fundamentally, the bailout consists of the two groups most responsible helping each other out, with our money. A friend of mine has described the “Nutsack Bailout Plan.” Any Wall Street firm that wants a piece of the bailout has to let someone kick every CEO they’ve had for the last ten years in the testicles. Throw in key members of Congress and executive branch responsible for oversight and I’m in.